Bonds
What are bonds?
Companies and countries need extra capital from time to time. While borrowing is a familiar concept to most of us, the investment world offers an exciting opportunity - to be a lender and reap the rewards. This is where bonds come in.
Put simply, bonds are securities based on debt. When you buy a bond, you are effectively lending money to the party that issued it - be it a government or a company. In return for the loan you receive, as an investor, you receive regular interest payments and, at the end of the loan period, you also get back the principal amount borrowed. This makes the bond an attractive investment for those who want to add a stable income and some security to their portfolio.
In this article you will find answers to the questions:
What is a bond?
What are the sub-categories of bonds?
How to make money with bonds?
What are the advantages and disadvantages of bond trading?
What are the risks associated with bonds?
How to trade bonds?
What are the sub-categories of bonds?
The different categories help you to orientate yourself and make informed investment decisions. Below we have highlighted the more general categories.
Classification by issuer:
Government bonds
Government bonds are known as a lower-risk investment. They are backed by the solvency of the government, so the probability of default is low. At the same time, government bonds generally pay lower interest rates than other categories.
Corporate bonds
Companies issue bonds to raise additional capital. These bonds can offer a higher interest rate compared to government bonds, but also carry a higher risk. The financial stability and creditworthiness of the issuer largely determine both the interest rate and the risk of the investment.
Interest rate principle:
Fixed-interest bonds
The investor is guaranteed a fixed interest rate throughout the investment period. This ensures a predictable and stable income stream.
Variable rate bonds
The interest rate on these bonds is linked to market rates, such as EURIBOR. This can offer potentially higher returns, but also carries a higher risk as returns can fluctuate.
On the existence of a guarantee:
Guaranteed bonds
At the time of the bond issue, the issuer guarantees an asset or income stream (for example, real estate). This provides the investor with an additional sense of security should the issuer default. The collateral may reduce the potential interest rate somewhat compared to unsecured bonds.
Unsecured bonds
These bonds are not backed by the assets or proceeds of the issuing party. While this may mean a higher interest rate for the investor, the risk is also higher. If the issuer defaults, the investor could lose both the interest and the principal amount borrowed.
How to make money with bonds?
There are two basic strategies for generating financial returns from bond investments:
Interest
This is the most traditional way to make money with bonds. The interest rate on a bond is fixed at the start of the investment and paid out to the investor periodically (usually quarterly or annually).
The amount of interest depends on a number of factors, including the creditworthiness of the issuer, the maturity of the bond and market conditions. Government bonds generally offer a lower interest rate, but are also lower risk. Corporate bonds may offer higher yields, but are also associated with higher risk.
Capital appreciation in the secondary market
Although the face value of the bond (the amount borrowed) is fixed, the bonds are traded in a secondary market similar to that for shares.
Bond prices can move higher or lower depending on supply and demand. This allows a savvy investor to buy a bond at a lower price and sell it later at a higher price, generating capital gains.
However, it should be borne in mind that bonds generally have a lower potential for capital growth than equities.
Advantages and disadvantages of investing in bonds
Here's a brief overview of the pros and cons of investing in bonds.
Benefits
Cons
Stable revenue stream
The regular interest rates on bonds offer investors a stable and predictable income stream. This is particularly important for investors who want to secure their income.
Lower risk compared to equities
In general, bonds are less risky investments than shares. Evaluating the creditworthiness of the issuer and selecting categories can help further mitigate risk.
Diversification
Bonds help investors diversify their portfolios by reducing the impact of stock market volatility.
Lower return potential compared to equities
Bond yields are usually lower than dividends on shares or the long-term price potential of shares.
Interest risk
A rise in market interest rates can push down bond prices, especially if they are variable rate bonds.
Inflation
Inflation reduces the real value of bond yields over time.
Risks of investing in bonds: it's important to be aware
Bonds are known for their relative stability among investment instruments, but this does not mean that they are completely risk-free. Before investing in bonds, it is important to be aware of potential risk factors:
Issuer default risk
This is one of the main risks of investing in bonds. If the country or company that issued the bond defaults, the investor could lose both regular interest payments and the principal amount borrowed. Although this risk is low for government bonds, it is still present. In the case of corporate bonds, the probability of default depends on the financial sphere of the issuer. Credit rating agencies assess the creditworthiness of issuers and assign them credit ratings to help investors assess risk.
Interest risk
Market interest rates are subject to change. When interest rates generally rise, bond prices usually fall. This can lead to losses if the investor decides to sell the bond before maturity. Fixed-rate bonds are less affected by interest rate risk fluctuations because the investor receives the interest rate agreed at the beginning throughout the investment period.
Inflation risk
Inflation is the general upward trend of prices in the economy. When bond yields are fixed, inflation can erode bond returns over time. For example, if inflation is 5% and the bond interest rate is 3%, then the real return on investment is negative (-2%).
Buying and selling bonds: how to trade
Bond trading is a potentially profitable investment strategy, but it is not risk-free. Before investing, it is important to gain the necessary knowledge and consider your financial situation.
Bonds offer investors the opportunity to make money in two main ways, one by providing a service and the other by playing the market.
1. Providing a service to the issuer e.g. buying a bond:
- Lending: When you buy a bond, you are actually lending money to the government or company (the issuer). This is a service provided by the investor to the issuer.
- Interest as a fee: In return for the loan, you earn regular interest. The interest is usually fixed and paid out periodically (for example, quarterly or annually).
- Loan repayment: At the end of the loan period, you will also get back the amount originally invested. This ensures the security of your investment, unlike shares, which can fluctuate wildly in value.
2. Playing the bond secondary market:
- The secondary market for bonds: Although bonds have a fixed maturity at the time of issuance, they are traded on the secondary market in a similar way to shares.
- Price volatility: The price of a bond fluctuates according to market supply and demand. This creates the opportunity for a savvy investor to buy a bond at a lower price and sell it later at a higher price, generating capital gains.
- Risk and potential: Compared to interest rates, this is a riskier way to invest, but it also offers potentially higher returns.
- Opening an investment account: To buy bonds, you need an investment account with a brokerage firm.
- Choice of bond: Research and choose the type of bond that suits you, taking into account your risk tolerance, return expectations and investment objectives.
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Placing a purchase order: Through your broker, you can place a buy order for the selected bond, specifying the quantity and price.
In addition:
- Investment horizon: Think about your investment horizon - whether you plan to hold the bond to maturity or sell it on the secondary market earlier.
- Transaction costs: Take into account the transaction costs involved in buying and selling bonds.
Which way might suit you?
When choosing bonds and creating a strategy, it is important to take into account your investment objectives and risk tolerance.
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Income security: If you want a stable income in the form of interest payments, fixed-rate bonds are suitable.
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Growing capital: If you are prepared to take a higher risk, trading in the secondary market for potential capital gains may be suitable.
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Portfolio diversification: Bonds help investors diversify their portfolios by reducing the impact of stock market volatility.
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